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Monday, November 23, 2015

The Size of Automatic Stabilizers in the US Budget

The notion that bigger budget deficits (or smaller surpluses) can help to stimulate an economy in recession, and that smaller budget deficits (or bigger surpluses) can help to prevent an economy from being overstimulated into inflation, are the core ideas of countercyclical fiscal policy. As every intro econ textbook points out, this countercyclical fiscal policy can be "automatic" or "discretionary."

Discretionary fiscal policy is perhaps easier to understand: for example, it's when government passes new laws to raise spending or cut taxes in a recession. But automatic countercylical fiscal policy--also called "automatic stabilizers"--happens without any new legislation being passed. When the economy heads south so that incomes and profits fall, less in taxes is collected automatically, with no need for new legislation. When the economy booms so that incomes rise, there is automatically less need for government programs like Medicaid or welfare payment, again with no need for new legislation.

How big are the automatic stabilizers? Frank Russek and Kim Kowalewski offer some estimates, along with lots of detail about how these calculations are made, in "How CBO Estimates Automatic Stabilizers," published in November 2015 as Congressional Budget Office Working Paper 2015-07. They write:

Most types of revenues—mainly personal, corporate, and social insurance taxes—are sensitive to the
business cycle and account for most of the value of the automatic stabilizers. A relatively small part of
total outlays—those for the programs that are intended to support people’s income and have a cyclical
component—contribute to the value of the automatic stabilizers; those benefits include ones from
unemployment insurance, Medicaid, and SNAP (the Supplemental Nutrition Assistance Program). The
automatic stabilizers do not include discretionary spending because that spending (which requires
legislation) is not automatic or interest payments because those outlays are not designed to provide
income support.CBO’s estimates of the automatic stabilizers are based on the estimated cyclical elements
of those revenues and outlays. The magnitude of the automatic stabilizers is zero when the economy is
operating at its potential and grows as the economy operates further away from its potential.

To get a sense of the size of automatic stabilizers in the US economy, here's are a few figures. The first shows how automatic stabilizers on the revenue side affect federal budget deficits. The second shows how automatic stabilizers on the spending side affect budget deficits.

A few patterns emerge from these figures. The timing of the automatic stabilizers is about right. For example, if one looks at the size of the most recent recessions in 2001 and in 2007-2009, you can see the automatic drop in tax revenues and the automatic rise in spending. The automatic changes in tax revenues are typically larger than the spending changes. And taken together, the effects of automatic stabilizers are substantial, combining in the 2007-2009 recession to equal about 3% of GDP.

If you combine the automatic stabilizers on the revenue and spending sides, and put it on a graph with actual deficits, here's what it looks like.. The light blue line shows how the budget deficit actually changed, including both automatic stabilizers and discretionary changes. The dark blue line shows how the deficit would have changed with the automatic stabilizers subtracted out. Clearly, discretionary policies have a bigger effect on overall deficits than do automatic stabilizers. But in helping to counterbalance economic swings, the automatic stabilizers remain useful.

The existence of automatic stabilizers is one reason why it would be foolish to require that the federal budget be balanced in every year. Think about it: a recession arrives, and so tax revenues automatically fall and spending in recession-related categories automatically rises. A true believer that the budget should be balanced each year would have to argue that in the fact of that recession, taxes should be hiked and spending cut to offset the changes of the automatic stabilizers.